Another entry in the long running debate over Michael Kinsley’s alleged proof that social security privitization is doomed to failure. This from a very smart college senior studying economics:

Michael Kinsley’s proof that privatization of Social Security is a certain failure is anything but logical. His argument rests on two false assumptions: that any increase in returns for people who buy stocks must come at the expense of bondholders and that diversified investment in stocks is riskier than investment in bonds in the long term.

The returns long-term stockholders earn are the result of real increases in value of the underlying share of a company’s assets. If people who buy stocks earn higher returns, those returns reflect a more productive use of capital rather than winnings in a zero-sum game at the expense of bondholders. Transactions in the stock market enable the businesses which are best able to make productive use of funds to receive them from the investors best able to forgo current consumption in favor of future returns. While the issuing company only receives funds from the initial issuance of stock, subsequent sales and purchases by investors provide liquidity (making the initial stock offering less costly to the businesses) and ensure that businesses have use of adequate capital from the people best suited to provide it. Gains in the stock market come at the expense of other investors (in stocks or bonds) only in short-term arbitrage not relevant to the privatization of social security.

For long-term investors, stocks can actually be less risky than bonds. Even bonds with a negligible risk of default carry risk because during times of high inflation bondholders earn a less-than-market interest rate. Stocks are less subject to inflation risk because they represent shares of underlying assets and the revenue streams they generate. If inflation rises, the underlying assets retain their value in real terms, and their prices in dollar terms by and large follow the prices in the rest of the economy. Investment in a widely diversified portfolio of stocks sharply reduces the risk that any one business will fail and deprive retirees of their savings. A well-thought-out privatization plan could address individual stock risk and short-term market risk by requiring participants to invest in broadly based mutual funds rather than specific stocks and by mandating a shift from stocks to bonds as individuals approach retirement age.